First Marblehead: Little Risk Priced In

I can’t help cleaving to the old models, and will continue to hammer away at the themes touched upon in an earlier post, patiently awaiting further enlightenment as to the obvious flaws of my analysis. As far as offering specious arguments, we’ll let the wider audience decide on that one, since no real alternative to valuing the stock using a method with any theoretical underpinnings has been provided. The feedback on First Marblehead (NYSE:FMD) suggests the temperatures haven’t cooled at all.

The “debate” is reminiscent of the feverish arguments over Freddie/Fannie in the late Nineties, when voices of skepticism were shouted down or ignored. Of course we all know how that ended. In the spirit of adding to the debate rather than engaging with those with an axe to grind, I’ll put my two cents as to why this stock is more expensive than the whole universe of 80+ financials that form part of the S&P financial sector. I will not [at least for now] delve into the detailed overview of GOS and securitization margins, residuals, [marginal issues at this juncture]. Nor will I address the worrisome issues advanced as to potential growth in student loan demand.

One of the most bullish analysts on First Marblehead (FMD) does appear to be the Bankstocks.com team. I won’t bother with the “minutiae” [their words not mine], but will attempt to wrap my arms around the stock’s valuation and what is imputed from the current stock price. Unless convinced that a different valuation framework can be valid here, using price/book for assessing fair value for FMD [and all financials, broad as that term may be to even include servicers] seems like the only sensible thing to do. The bulls don’t really address the valuation matter directly, and the 2007 [split adjusted] estimate of some $3.50 [consensus] suggest approximately 50% growth in EPS [over 2006] is expected.

However, I would hazard that 50% per share earnings growth may be closer to what the “market” is discounting not just in fiscal 07 [ends June], but in 08, and 09 as well.

But here is a big disconnect [between Street estimates and the “owners”]. Consensus expectation in 08 and 09 is for low-teens growth, though it they seem like low conviction estimates with FMD being given very little credit, as of today’s date [chances are these are low balled numbers]. To their credit, bankstocks.com report went to great lengths to detail the mechanics of FMD’s business model, but to a much lesser extent in my opinion, the economics of the model. So far, so good. There was plenty of detail, and even quite a bit of honest assessment that “it is a lending business after all”.

So what am I missing? The best lenders [bar none, except for AMEX, another short] generate low twenty ROEs. The top-tier underwriters/originators/servicers have sustained these numbers for ten years running in one of the most lucrative periods for credit businesses. But the burden of proof that FMD can sustain 40% to 50% ROEs is on them.

Investors buying into the story should look at history and the sector for perspective. The highest ROEs among all financial institution businesses [besides FMD of course], can be dug up in the footnotes of companies like Countrywide Financial Corporation (CFC), Wachovia Corporation (NASDAQ:WB) , Bear Stearns (NYSE:BSC), or Goldman Sachs (NYSE:GS). But a brief glance at parent company consolidated ROE's and valuations suggests 40%_ plus ROEs are minuscule in size relative to these whole companies and generally well hidden from competitors’ view. And for the most part even medium risk businesses with 20% ROEs would be very welcome additions to the portfolios of JP Morgan (NYSE:JPM), Wells Fargo (NYSE:WFC) and Bank of America (NYSE:BAC). So does FMD’s “competitive advantage” shelter it properly?

In my opinion, little risk is being priced in, while a lot of intangible value is being assigned to a business model with a relatively short track record, despite 20 years of student lending data [Come on guys; is that really worth much? COF’s army of analysts could slap something together in weeks looking for an angle here.] Perhaps excess returns [mid 40’s ROE average from 2004 through 2006] will endure for a few more quarters or even a couple of years. By my estimation, even with a decline in the ROE to 35%, it will take the company four years to earn its way into the current valuation. SLM is also on the skids, with unusual relative under performance over the last two years versus financials. Any suspicions as to why?

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